Investors are becoming increasingly aware of the fact that global markets will, at some point, move towards a higher interest rate environment. This will happen at varying speeds depending on the region, with the US and the UK most likely to raise rates before continental Europe for example.
Over the last 30 years the yield on US 10-year Treasuries has declined by around 25 basis points annually. As Michaël Malquarti, co-head of alternative investments at Syz Asset Management points out, not only has this led to a massive boost in bond prices but at the same time equity prices have also rallied. “Cyclically-adjusted PEs in the US have moved from less than 10 to more than 25,” says Malquarti.
The asset management industry has enjoyed an unprecedented period of falling yields, delivering healthy returns to investors’ traditional bond and equity portfolios but the world is on the brink of a new paradigm; one where rising rates will impact duration-sensitive assets and lead to lower, not higher returns, than investors have historically enjoyed.
“Without wanting to sound too dramatic, over a longer horizon the performance of a balanced portfolio, not only in nominal terms but also in real terms, is likely to be lower than what we have gotten used to.
“We are not saying that rates will necessarily be higher at the end of 2015. At best, rates will stay where they are now, oscillating between 1 and 3 per cent. So you buy a 10-year bond, the rate goes up to 2.5% or 3% and then falls back to 1.5%; on average, you don’t benefit from the movement in rates at all,” explains Malquarti.
It’s the same for equities. If the rates stay where they are now, it will require earnings growth to support higher equity prices or else P/E ratios will keep climbing to unsustainable levels.
“The whole asset management industry has to realise that we are coming to the end of a generation where bonds and equities enjoyed boosted returns. In that context, getting between 4 and 6 per cent by investing in hedge funds is becoming increasingly attractive,” adds Alexandre Rampa (pictured), co-head of alternative investments at Syz Asset Management.
In this new paradigm, hedge funds, given that they are not a distinct asset class and aim to generate short-term alpha – thus making them in effect zero duration investments – are likely to become more important to investors’ portfolios.
“Even if managers have a one-year outlook, that’s still very short-term when it comes to duration. That means you are exposed to a different return stream. What made them unattractive to some investors in the last few years when equity markets doubled, will, for the same reason, make them more attractive going forward,” says Rampa.
Moving forward, the best investors can hope for is that rates stay where they are. Even if that were to happen, bond and equity markets would not enjoy the boost in prices seen historically.
“Hedge funds will likely attract more capital as a result. Structurally, we are seeing a move towards passive investments so in a way the level of competition for hedge funds has decreased; the passive investment industry (e.g. ETFs) has grown significantly, and prop desk and bank trading activity has significantly decreased. This benefits active managers,” concludes Malquarti.